CapitalBudgeting_201.. - CITT

Capital Budgeting 

Learning Outcomes 

• Explain the concept and purpose of 

determining a firm’s cost of capital. 

• Explain the difficulty encountered in finding 

profitable projects in competitive markets and 

the importance of the search. 

• Determine the acceptability of investment 

proposals by discounted cash flow criteria 

using NPV and IRR methods. 

©2012, Varmelous Ind. Inc. -- Slide 1

The Concept of the Cost 

of Capital 

• In capital budgeting there are two 

major aspects to be considered: 

– The investment decision, and 

– The financing decision. 



of Capital 

• The investment decision is the decision to 

acquire an asset, a project, or product line, 

i.e., to buy, to lease, or not to lease. 

– It is partly derived from the management decision 

that requires a minimum rate of return 

expectation from such an investment. This rate is 

called by various names: hurdle rate, cost of 

capital, cut-off-rate, discount rate, or required rate 

of return (RRR). 



of Capital 

• The financing decision 

• The financing decision is a method of raising 

capital to make the investment decision, i.e., by 

creating debt, i.e. debentures, bank loans, leases, 

or by sale of equity, or both. 



of Capital 

• To summarize, the cost of capital is the rate 

of return on the firm’s total investments 

which earns the average rate of return 

needed to satisfy all the sources of longterm 

financing: 

• Therefore… 



of Capital 

• when the firm's rate of return is the 

same as its cost of capital on an 

investment project, the price of its 

common shares normally remain 

unchanged following the acceptance 

and implementation of the project, 

• and… 



of Capital 

• when the firm earns a greater rate of return than 

its cost of capital, the greater return will normally 

increase the value of the firm’s common shares and 

consequently, an increase in shareholder wealth. 

• Important to remember.. 

– The minimum rate of return that an investment is 

expected to provide in order to justify its acquisition is 

known as the hurdle rate, cost of capital, cut-off-rate, or 

discount rate, or the required rate of return (RRR). 



of Capital 

• It is important to note that investment and 

financing decisions should be based on the 

investor’s marginal cost of capital. Management 

should avoid using subjective criterion when 

analyzing investment and financing proposals. The 

marginal cost of capital has been determined in the 

financial markets. This encourages management to 

impose market discipline on its decisions. Finally, 

this approach ensures that market or intrinsic value 

is added to shareholder wealth. 


Difficulty and importance in 

finding profitable projects 

• Due to competition, it is difficult to find new project 

ideas that are profitable. 

• If a company develops a new and profitable 

product, it will not be long before other companies 

introduce a competitive product at a lower price in 

order to capture market share. Such competitive 

forces will result in lower profits and it may happen 

very quickly, especially if there isn't any barrier to 

entry into the market. 


Difficulty and importance in 

finding profitable projects 

• For companies to remain competitive and survive, 

they must practice timely investments in new 

profitable projects. 

• Putting into practice a strategy of implementing 

such investments shall require the use of capital 

budgeting techniques. 



• When evaluating a Proposed Capital Expenditure 

Net after-tax cash flows, and not accounting net 

income, are used to evaluate proposed capital 

expenditures. 

• Evaluation of a Proposed Capital Expenditure can 

be separated into two categories (methods), as 

follows: 

– Non-discounted cash flow techniques, and 

– Discounted cash flow (DCF) techniques 



• The major difference between the two methods of 

evaluation is: 

– Discounted cash flows recognize the time-valueof-money. 

As you may be well aware, a dollar 

today is worth more than a dollar tomorrow and 

much more than one five years from now. 



• Cash Flows: 

– The evaluation of a proposed capital project 

involves the use of net after-tax cash flows, (net 

meaning cash receipts less cash disbursements), 

rather than the concept of accounting net 

income. Cash in-flows are receipt of cash and 

cash out-flows are those transactions that 

require an expenditure of cash. 



• Cash Flow examples: 

– The Examples of cash in-flows are new or additional sales and 

savings due to lower or eliminated product costs or expenses. 

– Examples of cash out-flows are additional purchases of materials, 

increased cost for labour or other overheads (indirect expenses), 

such as the incremental increase in: rent, utilities, taxes, and 

other similar expenses that require a cash disbursement, related 

to the project. 

• Some expenses do not require a cash out-flow and are not directly 

considered in the cash flow analysis. Examples of such expenses are 

any form of amortization (depreciation or depletion) of a capital 

asset. 



• Discounted Cash Flow example: 

• The cash flows in the example presented are 

somewhat simplified. Some of the elements of the 

cash flow analysis, such as tax shields, which are 

the result of depreciation for tax purposes, known 

as Capital Cost Allowance, (commonly abbreviated 

as CCA) will be provided without supporting detail. 

The Finance department of your company would 

usually provide such details. 


Discounted Cash Flow – 

Net Present Value (NPV) 

• Discounted cash flow techniques base the decisions 

on the investment’s cash flows after it is adjusted 

for the time value of money. 

• In this presentation we will ignore the problem of 

incorporating risk into capital budgeting decisions. 

Also, the appropriate required rate of return 

(R.R.R.) will be given. 




• The two most frequently used discounted cash flow 

evaluators are: 

• Net Present Value (NPV) which measures discounted cash 

flows in versus discounted cash flows out, using the stipulated 

required rate of return, and 

• Internal Rate of Return (IRR) which is the rate of return at 

which the discounted cash flows in are equal to the 

discounted cash flows out, i.e., net present value is equal to 

zero. 

• Both of these methods have similar advantages and 

disadvantages. 




• The main advantages are: 

• All net cash flows over the life of the project are considered in 

the evaluation, and 

• The time value of money is recognized, i.e., earlier cash flows 

are better (worth more) than are later cash flows. 

• The main disadvantages are: 

• Much detailed information must be identified and gathered, 

and 

• Calculations can be time consuming and complex. 




• However, modern personal computers with 

spreadsheet software have negated much of the 

computational complexity and allow for almost 

instantaneous what-if scenarios for alternate 

consideration in the evaluation process. 

• The use of recent integral computing techniques 

contained in most spreadsheet programs like Excel, 

make the computation of both NPV and IRR 

relatively simple. Tools like Goal Seek will facilitate 

the computation of IRR once NPV has been 

calculated using the requisite data. 




• The project’s NPV is the net value in today’s dollars 

of the cash in-flows and out-flows. The TVM factor 

is not violated because all of the cash flows are 

discounted back to the present. The deciding 

criteria are: 

• NPV => 0, accept project because the project’s return on 

investment (ROI) is equal to or greater than the firm’s 

required rate of return (RRR). 

• NPV < 0, reject project because the project’s ROI is less 

than the firm’s RRR. 

• NPV = 0, then the project is returning the firm’s RRR. 




• The reason for the use of the Net Present 

Value (NPV) method is quite clear. 

– If a firm accepts a project with a positive NPV, 

the value of the firm will increase and thus 

so will the wealth of the current 

shareholders. 

– The inverse holds true, if there is a negative 

NPV the shareholder wealth will decrease. 




• Guidelines to Capital budgeting 

• In order to carry out capital budgeting analysis 

properly, we must identify net after-tax cash flows 

that are incremental with respect to the project 

under consideration and evaluate the attractiveness 

of these cash flows relative to the project’s cost. 




• Cash Flows vs. Accounting Profits 

• We will use net after-tax cash flows, and not 

accounting concepts of income and expense, as our 

measurement tool. Because of the accrual method 

of accounting, a firm’s accounting profits and cash 

flows may not be timed to occur together. 




• Ignore Interest Payments and Financing 

Flows 

– Because the NPV method uses the Required Rate of 

Return (RRR), the financing decision is kept separate from 

the investment decision. 

– We are assuming for the most part that the firm’s cost of 

capital structure, i.e. shares, debentures, debt, etc. will 

not change by implementing the new project. Thus, 

interest payments and other financial cash flow issues 

resulting from raising funds to finance the project are not 

considered incremental cash flows. 




• Income Tax 

– When a corporation earns an income, it is required to pay 

taxes on that income to both the federal and provincial 

government. In the converse, if a corporation spends 

money to earn the income, they can deduct the expenses 

from the income and reduce the amount of income tax 

that needs to be paid. 

– The income tax rates differ by the type of business and 

the provincial residency of the corporation. 

– The rates that would be used in a capital budget project 

would be made available by the Finance Department. 




• Present Value Tax Shield 

• This item appears as part of the capital budget process. The 

information would be provided by the Finance Department. 

• Present Value Tax Shield — 

Lost on Salvage Value 

• This item appears as part of the capital budget process. The 

information would be provided by the Finance Department. 




• Cash Flows Diverted from Existing Projects 

• Do not include cash flows achieved that could have also been 

earned under the previous scenario. Again, this takes us back 

to the concept of thinking incrementally. 

• Incidental or Synergistic Effects 

• In certain situations, a new effort may actually bring 

additional sales to the existing product line. When analyzing 

the firm’s bottom line, we should consider any cash flow that 

may find its way into another part of the company as a result 

of adopting the new project. 




• Account for Opportunity Costs 

• Opportunity costs cause negative cash flows because the 

firm’s existing assets are being diverted from existing projects 

to the newly implemented project. The firm loses the cash 

flows that would have been obtained from the previous 

projects. 

• Consider Incremental Expenses 

• Just as cash in-flows from a new project are measured on an 

incremental basis, expenses should also be measured on an 

incremental basis. 




• Sunk Costs Are Not Incremental Cash Flows 

• The NPV method requires that we concern ourselves with 

cash flows that are affected by the decision making at the 

moment. If the cash flow happens regardless whether the 

project is accepted or rejected, than it has no bearing on the 

NPV decision. 




• Include Working-Capital Requirements 

• Working-capital requirements are considered a cash out-flow. 

For example, an additional investment in inventory is 

considered a cash out-flow when the goods are held because, 

while the goods are kept inside the stock room, the firm does 

not have access to the inventory’s cash value. The firm loses 

the opportunity to use the money for other investments 

during the life of the project. Upon termination of the project, 

there may be a partial recovery of the initial amount invested 

in working-capital. 




• Cash Flows from Changes in Overhead 

• The NPV method requires that we include any incremental 

cash flow that causes a change in overhead expenses. 

• However, one must take care in ensuring that this is a truly 

incremental cash flow. Quite often, overhead expenses are 

fixed and are incurred whether or not a project is 

implemented. 

• An example of a cash flow that would be included is if the 

new machinery actually reduces the direct labour costs and its 

associated costs, e.g. employee benefits, i.e. fewer machine 

operators. 




• Example Problem 

• The following business case will be used to develop a capital 

budgeting worksheet in Excel that will quickly calculate the 

NPV for this investment proposal. 

• The K. WattsaVolt Inc. Company, a manufacturer of electronic 

components is considering the purchase of a new fully 

automated machine, called the Eddison, to replace an older, 

manually operated one. 

• The following is the relevant information obtained: 





• The required rate of return on projects of this kind is 20%. 

• The company is in the 40% combined corporate tax-bracket, 

• Both machines belong to an asset class which Revenue 

Canada requires that they use the declining balance method 

CCA (Capital Cost Allowance) at a rate of 30%. 

• The project life has been set at 5 years. 

• The salvage value of this new machine is expected to be 

$12,000 after five years, and the asset class will continue to 

remain open. 





• In addition, an increase in raw materials and goods-in-process 

inventories would be required of $6,000. This increase in 

inventories would be recovered at the end of five years. 

• Inflation is estimated at the rate of 2% per year for wages, 

benefits, maintenance and defects. 

• It took three employees to operate the old machine, and they 

earned a combined total of $90,000 per year in wages. 

• The new machine will require only two more skilled 

employees for a total wage expense of $74,000 per year. 

• The fringe benefits are estimated at 25% of the wages. 





• The annual cost of maintenance and defects associated with 

the old machine were $10,000. 

• The annual costs of maintenance and defects on the new 

machine would be $3,500. 

• The replacement machine being considered has a purchase 

price of $70,000. 

• Shipping installation and testing of new machine is estimated 

at $8,350. 

• The old machine can now be sold for $25,000. 




NPV DCF Example – Input criteria 




NPV DCF Example – Present Value of Cash Flow 




NPV DCF Example – NPV of Cash Flow 



(IRR) 

IRR DCF Example – NPV = $0 of Cash Flow 



(IRR) 

IRR DCF Example – NPV = $0 of Cash Flow 

Since the IRR of 25.9% is greater than the RRR of 20%, 

the project would be accepted. 


About the presenter 

• Michel has developed and co-authored a Finance workbook 

for an Ontario college’s School of Business which is updated 

annually. He is also the author and provides instruction to the 

CITT association’s students on a senior level Web Based 

Distance Education Logistics Decision Modeling course. He has 

recently joined the School of Business Commerce and 

Business Administration at Vanier College in Montreal, 

Quebec. Michel can be reached by emailing him at; 

– bauermichel@hotmail.com

CapitalBudgeting_201.. - CITT

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